Sovereign debt is no longer the easily defined sector that it used to be. As investors run scared of many developed governments' debt and turn instead to the 'true' sovereigns of emerging markets, uncertainty and volatility reign in an area that was once so simple. Joanne Hart reports.

In more halcyon days, sovereign debt was relatively simple. Issuers had a pretty good idea of the pricing they could achieve; investors had a pretty good idea of where they wanted to invest and the levels at which they were prepared to do so. That was before the financial crisis, before the explosive growth of the BRIC economies (Brazil, Russia, India and China), perhaps even before the creation of the eurozone.

Now things are different. Sovereign credits once considered impregnable have blown up, countries once considered high-risk are turning away investors and volatility pervades the market. The very concept of sovereignty has been called into question.

"The term 'sovereign' is used very loosely these days. A true sovereign has its own currency and control of monetary and fiscal policy. This is crucial, because it means the credit risk is zero, although there is still interest-rate risk, currency risk and inflation risk. A true sovereign can always raise finance by issuing in its own freely floating currency," says Steven Major, global head of fixed-income research at HSBC.

And it is not just eurozone countries that have sacrificed monetary sovereignty, says Mr Major. "Dubai is part of the United Arab Emirates, which has a currency linked to the dollar, so it does not have the same amount of flexibility as true sovereigns," he says.

At one time, such analysis might have been considered pedantic, but recent events across the globe have shown it to be anything but. Late last year, Dubai came close to economic collapse and was forced to seek help from fellow emirate Abu Dhabi - to the tune of about $25bn. Earlier this year, the eurozone was thrown into crisis as Greece came close to default and its peers were forced to choose between participating in a €110bn rescue package or leaving the country to solve its own problems - a move that could have threatened the very existence of the euro.

After much prevarication, European governments took the rescue option, but the decision has angered many citizens - notably in Germany, where people feel they are bearing the cost of Greece's imprudence. Moreover, the consequences are wide-ranging, and there is no guarantee that Greece will not need further support.

"Having effectively ceded control of fiscal policy in return for external financing from the International Monetary Fund and the euro group, Greece now has very little sovereignty over its economic policy," says Mr Major. The Greek near-tragedy did nothing for investor confidence in government debt, particularly where the so-called 'peripheral' countries of the eurozone were concerned - Portugal, Ireland, Greece itself, Spain and, to a lesser extent, Belgium and Italy.

Short-lived positivity

At the very start of 2010, sovereign debt spreads were lower than they had been for most of the previous year, after having rallied during 2009. General confidence was also at reasonable levels. Austria, Belgium, Ireland and Spain all tapped the market in swift succession and the mood was still largely positive, taking down large-scale supply. However, this positivity was not to last, says Lee Cumbes, managing director in Barclays Capital's public sector origination team.

"With a number of news stories and market pressures combining as the weeks went on, [sovereign debt] conditions became much more volatile and it was clear that there would be pricing implications for some markets in order to capture the volume of funding on a consistent basis," he says.

The environment was so challenging that the eurozone had to act, creating the €750bn European Financial Stability Fund, designed to show investors that, if need be, there would be support for the 'peripherals'.

This facility - and the Greek support package - have gone some way towards allaying investor concerns but it has certainly not removed them altogether.

"On a two-year view, investors can mount a strong case for holding Greek paper, but the market thinks otherwise. There is a 900-basis-point [bp] differential between Greek and German bonds," says David Owen, chief European financial economist at Jefferies International.

"Many investors are hugely risk-averse at the moment, so the markets are not behaving rationally," he adds. Within the eurozone, this has resulted in what might be described as a three-tier approach to sovereign risk, reflected in the yield differentials.

"Tier one includes Germany, France, Finland and the Netherlands. Tier two comprises Italy, Spain, Belgium and Austria. And tier three includes Ireland, Portugal and Greece," says Mr Major.

Flight to safety

For many sovereign debt investors, Europe's tier one has become increasingly attractive. Not only has Greek vulnerability been shown up in graphic detail, but Ireland and Portugal have been forced to admit that their finances are in a parlous state too.

"Outstanding Greek government debt is heading towards 145% of gross domestic product [GDP]. Ireland's is more than 100% and the ratio could rise very quickly. Portugal has been recovering but it may slip back into recession," says Mr Owen. "Many long-only funds are fearful about their long-term reputation and if there is the slightest possibility of a country being downgraded or defaulting, they don't want to carry the risk. They have scaled back holdings of everything outside the core."

The 'core' is principally Germany, although France is not far behind. German bund yields have come down to record lows this year, as the inequality within the eurozone has become increasingly manifest.

"Ten-year bund rates fell from 3.4% in January to just over 2.25% in October," says Mr Cumbes.

The UK and US governments have also benefited from investors' aversion to risk. Ten-year US treasuries were yielding about 2.4% in October, while equivalent gilts were yielding less than 3%, both near historic lows. On a two-year basis, the figures are even starker - about 0.4% and 0.7%, respectively. Both governments have seen yields fall, partly because they are considered relatively safe, but also because they do have true economic sovereignty, and because they are engaged in quantitative easing programmes, specifically designed to boost liquidity.

David Spegel, global head of emerging market strategy at financial services company ING

David Spegel

David Spegel, global head of emerging market strategy at financial services company ING

Emerging markets blossom

Intriguingly, however, the intensely low yields of government debt for more secure developed nations has prompted a number of investors to seek out yield. And, in so doing, they are turning their backs on traditional wisdom and established behaviour.

"For certain investors, it is less compelling to go for investment-grade corporates than for emerging market sovereigns, many of which have their own currencies and stronger economies than their counterparts in the developed world. External and local-currency debt in Latin America, Asia and central and eastern Europe offer plenty of opportunities. Most importantly, there are higher yields and less solvency risk," says Mr Major.

Demand for emerging market sovereigns was highlighted in October, when Mexico issued a $1bn 100-year bond, the longest-maturity debt ever issued by a Latin American country. The transaction, priced to yield 6.1%, was well subscribed and the price rose after launch, sending the yield to below 6%.

In central and eastern Europe, the Czech Republic raised €2bn via a 10-year syndicated loan, which attracted more than €5bn of orders and was priced at just 3.625%. Compare this with the €6bn syndicated loan from Spain in July, which was also oversubscribed but was priced to yield 4.85%.

The Czech deal was assigned an A+ rating by the credit rating agency Fitch, while Spain had an Aaa Moody's rating at the time of issue (subsequently downgraded to Aa1).

Many observers suggest such deals indicate decreasing reliance on credit rating agencies. Most institutions have their own credit analysts and in-house due diligence is arguably more comprehensive than it has ever been. But the other big driver behind the success of emerging market sovereign transactions is the sheer weight of money.

"The amount of money going into emerging markets is rising all the time," says Carl Norrey, managing director at JPMorgan's global rates business. The statistics bear this out.

"There is huge demand. The level of inflow is amazing. Assets under management for emerging market funds grew 70% from the third quarter of 2009 to the third quarter this year and, within that, 67% related to new investor flows," says David Spegel, global head of emerging market strategy at financial services company ING.

The influx of money into emerging markets has had a dramatic impact on spreads. Brazilian debt, with a credit rating of BBB-, is priced at 106bps over interest rate swaps, while the spread for equivalent Portuguese debt is 400bps and that for Ireland is 440bps.

"It looks as if people don't believe the credit rating agencies when it comes to European peripherals," says Mr Spegel.

"The credit cycle has shown that emerging market sovereigns are fairly resilient, so the risk premium traditionally associated with these credits has been whittled away. The debt-to-GDP ratio in emerging markets is about 40% on average. In developed markets, the ratio went from 67% in 2009 to 85% this year and it is expected to increase further in 2011," he adds.

There are concerns however, that the popularity of emerging market sovereigns may be excessive. A significant proportion of retail money is invested in this sector too and this is liable to move elsewhere at the slightest hint of danger.

"Within real-money funds, some 50% of recent inflows [in the] year to date have come from the retail sector and this may not be terribly stable," says Mr Spegel.

Indeed, in some cases, the story is moving full circle. Crossover funds are so called because they invest in both developed and emerging market credits. Typically, they will allocate most of their funds to developed credits and 15% to 20% to emerging markets.

"Now, some dedicated emerging market funds are investing in peripheral European credits because they recognise the dynamics," says Mr Spegel.

Carl Norrey, managing director at JPMorgan's global rates business

Carl Norrey

Carl Norrey, managing director at JPMorgan's global rates business

Uncertain future

Looking ahead, opinions are mixed. Some market watchers believe the sovereign picture is improving: others believe many years of trouble lie ahead.

"The prognosis is less bleak than it was at the beginning of the year. The macro outlook is stronger, with less likelihood of a double-dip [recession] and a lot of the concerns that were around earlier in the year have now receded," says Greg Arkus, head of sovereign, supranational and agency capital markets at Credit Suisse.

Barclays Capital's Mr Cumbes also believes the landscape is brighter now than it was. "Earlier in the year, some quarters of the market had concerns about how Europe would hold together. But the European institutions acted decisively in the end to create a sizeable support mechanism and this has helped boost investor confidence," he says.

Others fear that the legacy of debt and deficit will overhang the sovereign market for several years.

"The legacy of debt-to-GDP ratios of 100% or thereabouts will be with us for a long time. Debt ratios are continuing to rise, budget deficits are problematic and peripheral spreads are very wide. We have been living through a potential crisis for three years and it is likely to continue for another three to five years," says Mr Norrey.

"The problem is not going to go away. We are talking about multi-year workouts for countries such as Greece, Ireland, Spain and Portugal," says Mr Owen.

Bulls and bears have evidence on their side. Looking purely at supply and demand, issuance next year, from European sovereigns at least, is likely to be the same or slightly less than this year - about €770bn, excluding very short-dated bills. Issuance from the private sector, meanwhile, is likely to decrease. And demand for credit continues to rise as investors search for places to put their cash.

"There is a lot of supply but there is massive deleverage in the private sector. And there is a huge demand for assets. Everyone in Europe is producing fewer assets and there is a strong desire to save," says David Watts, European credit strategist at CreditSights.

Sovereign market sceptics, however, highlight the enormous debt levels with which some countries are now saddled and suggest that the chance of default or delay remains strong.

"The problem is that economic growth is not on the horizon and all we can see is austerity. If a country is refinancing at 5% a year and its debt is 150% of GDP, the interest bill will be 7.5% a year, so they need to be growing really strongly to bring the debt down. Otherwise, it is like using one credit card to pay off another," says Mr Major.

A key question is whether one or more of the eurozone countries will need to restructure their debt. The reality is that nobody really knows.

"Investors don't know what to believe. There is very rarely a single house view," says Mr Owen.

Indeed, the one point on which all observers agree is that uncertainty and volatility will continue to dominate the sovereign market for some time.

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